GAO's calls for federal regulation of derivatives are unfounded and go too far, dealers complain.

WASHINGTON -- While most major derivatives players complain the General Accounting Office's call for federal regulation of derivatives is unfounded and over-reaching, a few market participants say more federal oversight is needed.

The GAO, in a derivatives report that was issued a week ago, concludes that all over-the-counter derivatives dealers should be regulated under comprehensive and consistent federal standards -- including affiliates of securities firms and insurance companies that are largely unregulated by federal agencies.

The report also calls for the Securities and Exchange Commission to ensure that registered corporate users of derivatives establish internal controls and public reporting requirements for their derivatives activities.

Most of the major derivatives players criticized the GAO report this week, complaining that the recommendations go too far and are not supported by the detail in the report.

"Some of their conclusions are not supported by the text," said an official with a major derivatives dealer who did not want to be identified.

The report does not provide evidence that derivatives pose increased systematic risks and that derivatives affiliates of securities firms need to be regulated, he and other market participants said.

Systematic risk is the risk that the insolvency of a major derivatives counterparty or some other derivatives crisis could snowball and have disastrous consequences for global financial markets.

Jerry Quinn, staff adviser of the Securities Industry Association's swaps and over-the-counter derivatives products committee, said the report is dated and fails to recognize some of the actions that derivatives market participants have either taken or proposed to take to ensure their derivatives activities are conducted in a safe & sound manner.

The report "took about two years to put together, and frankly, it shows it," Quinn said. "It's much more of a snapshot in a particular point in time a couple of years ago than it is a demonstration of how the market is evolving."

Quinn said the report ignores the fact that several of the major derivatives dealers have set up subsidiaries with triple-A credit ratings in which to do their derivatives business.

"Triple-A ratings are as rare as hens' teeth," he said. Firms must meet tough capital standards and submit to continual monitoring to get these ratings, he said.

But an SEC official said the SEC would never rely on credit ratings to ensure that firms are maintaining adequate levels of capital. Credit rating agencies do not subject firms to reporting requirements, examinations, or audits, the SEC official said. In addition, not all credit rating agencies have the same process or standards for obtaining ratings, he said.

Quinn complained that the GAO report also fails to recognize that the major derivatives dealers are trying to work with the SEC and other agencies to set derivatives standards that could be voluntarily complied with.

"This is an overture to a supervisory framework," he said.

A number of market participants and a federal regulator said securities firm and insurance company affiliates should not be federally regulated and held to the same standards as banks.

"There's no safety net for securities firms and insurance companies," said the regulator, referring to federal deposit insurance.

Most market participants were concerned about the GAO's recommendations for the SEC to more closely monitor corporate users of derivatives.

"This is the expansion of the role of government into good business management. It's scary thought," said another official at a dealer firm who did not want to be identified.

But other market participants and observers agreed with the GAO that all derivatives dealers should be subject to some federal oversight.

"I'm probably in the minority, but I share some of the GAO concerns," said a regional dealer who participates on an industry derivatives panel and did not want to be identified.

"I am concerned that there are systemic risks. Because there are such big players in the market, there needs to be some insurance that people are playing by the rules," he said. "I support self-regulation, but something more is needed."

Michael Maples, a vice president with responsibility for derivatives at J.J. Kenny Co., said, "We think that the federal government needs to oversee and regulate derivatives, but it would be a mistake to regulate them out of existence."

Derivatives benefit firms and the financial markets and "should be nurtured," Maples said.

Critics of the GAO report said they are not worried about Congress enacting pending or soon-to-be proposed bills that would carry out the report's recommendations.

Federal regulators and a number of lawmakers on banking and securities panels remain insistent that legislation is not needed, the critics say. Congress appears to be too busy to deal with derivatives legislation this year, they say, and that gives market participants more time to make the case that they and the federal agencies are taking the steps that are needed to ensure derivatives do not pose undue risks.

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